January 13, 2003

Deficit Reduction

Perhaps the hardest part of criticizing the Bush administration's
economic logic is simply keeping track of it from week to week.
Consider President Bush's view of deficits. His initial position,
while peddling his tax cut on the campaign trail and in the first
months of his presidency, was that a return to deficits was
inconceivable. "We can proceed with tax relief without fear of
budget deficits, even if the economy softens," he said in March
2001. "The projections for the surplus in my budget are cautious
and conservative." When, in the late summer and early fall of that
year, budget forecasts first showed deficits on the horizon, he
dismissed them as "speculative" and "guesswork." When finally
forced to acknowledge the inevitability of deficits last spring, he
insisted they would be "small and temporary." Meanwhile, he'd begun
laying the groundwork to shift the blame away from his tax cut and
onto such factors as the September 11 attacks, the recession, and
big-spending Democrats. But, with the recession and the terrorist
attacks now receding into the past and unified control of the
government in GOP hands, deficits are still projected to remain a
large and permanent feature of the Bush presidency. And so it has
become necessary for the administration to retreat to yet another
new line of defense: Deficits don't matter.The turnabout is fairly remarkable. Last spring, Bush said, "I'm
mindful of what overspending can mean to interest rates or
expectations of interest rates. " As recently as September, he
argued, "For the sake of fiscal sanity, the United States Senate
must ... get us to head towards a balanced budget." But, since
Republicans took the Senate in November, the White House has begun
arguing that it makes no macroeconomic difference whether the budget
is balanced or not. The point man for this argument is R. Glenn
Hubbard, the chairman of Bush's Council of Economic Advisers.
Hubbard has pooh-poohed the impact of deficits before, but now his
arguments are taking on a new prominence, with the White House
issuing charts and graphs bolstering his case. "One can hope that
the discussion will move away from the current fixation with
linking budget deficits with interest rates," Hubbard declared in a
December speech. When asked about deficits raising interest rates,
he sneered, "That's Rubinomics, and we think it's completely
wrong."

The Bushies use the phrase "Rubinomics" so often, and with such
contempt, that you'd think Robert Rubin was some sort of convicted
swindler rather than a widely admired Treasury secretary. The
phrase refers to the strategy developed in the first year of the
Clinton administration. Inheriting a still-sluggish economy, the
Clintonites decided, after much internal deliberation, to
concentrate on deficit reduction--on the theory that this would
lower long-term interest rates and thereby help stimulate economic
growth. As surpluses appeared in the late '90s, Rubin and others
argued for using them to pay down the national debt rather than to
cut taxes or increase spending, for essentially the same reason.
The result, of course, was fairly spectacular.

Now, one can argue that the '90s boom had little to do with
"Rubinomics." But the Bush administration isn't merely disputing
the importance of fiscal discipline; it's denying the factual
premise that deficits affect interest rates--an elementary
assumption shared by liberal and conservative economists alike.
Interest rates, after all, are the price of borrowing money. There
is only so much money out there to be borrowed at a given price.
When the government borrows hundreds of billions of dollars, the
supply constricts, raising the price for everybody else. Similarly,
if Washington were to purchase a large chunk of the orange harvest
and throw it into the Potomac, the price of oranges would, other
things being equal, rise.

How, then, could the self-proclaimed free-marketers at the White
House deny this supply-demand effect? Hubbard argues that global
capital markets have made deficits virtually irrelevant. If
government borrowing soaks up capital that would otherwise be used
by U.S. businesses, this line of thinking goes, then overseas
investors will just take up the slack. "Not surprisingly," he told
an audience last month, "the evidence is that long-term interest
rates do not move in lockstep with actual or expected federal
budget changes."

But, while it's perfectly true that foreign investment can help
cover for Washington's red ink, this doesn't make deficits any less
bad. The ultimate problem with deficits is that they reduce the
national savings rate, which is the proportion of our annual income
that is not consumed. The savings rate is important because it
measures Americans' ownership of productive assets--such as
companies--that can produce future income. When the government runs
deficits, it dips into the pool of money that would otherwise be
used for buying productive assets and instead ties it up in
financing government debt. Now, if you assume that foreign
investors will replace every lost dollar, then interest rates won't
rise, but that still does nothing for our savings rate. It simply
means that companies that would have been producing future income
for Americans will instead be producing future income for overseas
investors. "Instead of reducing the domestic capital stock," write
William Gale and Peter Orszag of the Brookings Institution, "budget
deficits would represent a mortgage of the income from that
capital, with the mortgage owned by foreigners."

So, even if Hubbard's argument were correct, it wouldn't mean that
deficits don't harm the economy. It would only mean that long-term
interest rates no longer reflect the level of harm they do. But, in
any case, Hubbard's argument isn't correct. While global capital
markets do reduce the link between deficits and interest rates,
they don't make it disappear completely. Supply-siders like Hubbard
like to point out that most historical studies find no such
linkage. But that's because long-term interest rates are controlled
by many factors other than deficits, which makes it difficult to
prove a clear correlation. For instance, economic slowdowns cause
deficits to rise, but they also tend to prompt the Federal Reserve
to reduce the overnight lending rate, which lowers long-term
interest rates, too. A perfect example of this phenomenon was
brought up by, of all people, Hubbard himself. In his December
speech, he pointed out that the interest rate on ten-year Treasury
bonds is now nearly a full point lower than it was in January 2001,
even though budget projections have moved from surpluses to
deficits. Hubbard took this as yet another case of deficits failing
to lead to higher interest rates. But of course the real reason
rates fell is that the Federal Reserve aggressively cut short-term
rates to help revive the economy. If it weren't for projected
deficits, long-term rates would be even lower.

When Hubbard and other Bushies insist that there's no empirical
evidence linking deficits with interest rates, they make a crucial
error. If you look at the year-to-year

numbers--say, the 2001 deficit and 2001 interest rates--they're
right. But the market for long-term interest rates is
forward-looking. What really moves it is not one-year spikes in the
budget but changes in the long-term economic picture. Gale and
Orszag, in a Brookings paper, compiled all the historical studies
that compare long-term interest rates with expectations of deficits
(e. g., forecasts from the Congressional Budget Office). And they
found that such studies overwhelmingly show a correlation between
deficits and interest rates. "[S]tudies that (properly) incorporate
deficit expectations in addition to current deficits," they
conclude, "tend to find economically and statistically significant
connections between anticipated deficits and current long-term
interest rates." Of the 19 studies that have failed to show any
relationship between deficits and interest rates, all but one
either did not account for expectations or did so only indirectly.
Meanwhile, of the 17 studies that did account for expectations, all
but one showed a correlation.

In other words, economists have been right all these

years: The laws of supply and demand do hold. When you constrict the
supply of money available for borrowing, the price of borrowing
goes up. Somebody inform the Bush economic team.